This question is a dilemma for family child care providers.
For decades I have advised providers to claim all the allowable business deductions you are entitled to, so as to reduce your profit and reduce your taxes.
Lower taxes are good in the short run, but they will also reduce your Social Security benefits in the long run.
Your Social Security benefits are based on the highest thirty years of earnings over your lifetime. The higher your business profit, the greater your Social Security benefits.
Therefore, the question becomes, “Are you better off continuing to claim all of your business deductions or should you not claim some deductions to get a higher Social Security benefit?”
In my opinion, you should claim all business deductions even at the risk of lower Social Security benefits. You should then invest your tax savings each year in your own IRA to generate additional retirement income.
Social Security Benefits
To discover how much you will receive in Social Security benefits go to the Social Security website. There you can also use their Retirement Estimator to project your future earnings and get a more accurate estimate of your benefits.
Let’s say you wonder what the impact of reducing your business expenses by $5,000 would have on your Social Security benefits. By entering in lower estimated of future earnings into the Retirement Estimator you can see the result.
Let’s look at some general examples based on the following assumptions. You are currently age 60 and want to retire at age 65. You are earning a $35,000 profit. You want to know the impact on your Social Security benefits if you reduced your business expenses by $5,000 and reported a higher $40,000 profit until you retired.
Under this scenario, your Social Security benefits will rise from $18,356 a year to $19,840 a year. That’s an increase of $1,484 for each year in retirement. Not bad. If you were age 45 and did this for twenty years your Social Security benefits would increase by $1,806 per year. Here’s a simple online calculator that can help you run various scenarios.
However, if you didn’t reduce your expenses you would save about $1,500 to $2,000 per year in taxes ($5,000 expenses x 30-40% tax bracket). At age 65 (after 5 years) you would have an extra $7,500 – $10,000.
You could then invest this extra money in an IRA and boost your retirement income.
It is difficult to compare the precise financial impact of this decision. There are many variables, including taxes on Social Security benefits, your health, your age, your past financial earnings, IRA investment earnings, and so on.
Before making a decision to reduce your profit, consult with a financial planner who can help you understand the impact for your individual situation.
I continue to believe it’s better to keep claiming your deductions and use your tax savings to fund your IRA.
Tom Copeland – www.tomcopelandblog.com